The PROBLEM With Covered Calls (Are They Worth It?)

covered calls are one of the most popular options trading strategies in the entire universe but do they live up to the hype in this video we are going to explore whether or not covered calls are a holy grail strategy or if they can sometimes do more harm than good covered calls are one of the most popular options trading strategies out there because they are very simple to set up only requiring you to own 100 shares of stock and by doing so you can create an income stream on those shares of stock that you already own and lastly they can reduce the losses on those shares in the event of a share price decrease so when we combine all of these things together covered calls seem like a win-win and it seems like it's a strategy that can only benefit you as a quick recap a covered call consists of shorting one call option against 100 shares of stock that you own so for example i currently own 200 shares of square with the ticker symbol sq now since i own 200 shares of square i can set up a covered call on this entire share position by shorting two call options so one call option for each 100 shares of stock that i currently own and by doing so i would create a covered call position just a quick heads up that tasty works is running a special promotion through september 30th 2021 where if you open and fund your first account with them you can earn up to 200. worth of crypto when you fund that account with two thousand dollars or more if you don't have that much money if you open and fund with two hundred dollars you will get fifty dollars worth of crypto and again this offer runs through september 30th 2021 if you want to learn more about that please check out the link down in the description below to get started i currently own 200 shares of square with an average purchase price of right around 190 per share and with square trading at around two hundred and sixty dollars per share i currently have a seventy dollar gain on my two hundred shares of stock meaning that i'm up about fourteen thousand dollars overall on this share position but let's say i wanted to create a covered call with this square position and by looking at the chart let's say i thought that the 280 price level was going to continue to be a level of resistance for square shares and because of that i wanted to create an income stream on the shares that i currently own by setting up a covered call position and since i just mentioned that my outlook is that maybe square is going to have a tough time getting through that 280 price level let's say that i use the 280 level as the strike price for my covered call position and let's say my outlook for this or my time frame for this trade is approximately two months based on that we can go to the september 2021 expiration cycle and we can go to the 280 strike call options and based on this we can see that these options are trading for right around nine dollars per call option meaning that with a premium of 900. attached to that option if i shorted two of these i would collect eighteen hundred dollars into my account and i would successfully set up a covered call position in square let's walk through four different scenarios that could play out with this potential covered call in square the first scenario is that the shares traded fairly neutrally so let's say by the time of september 2021 expiration the share price of square is still right around 260 dollars per share in this scenario i would not really make or lose any money on the shares that i currently have but since the share price is below the strike price of 280 those 280 calls would actually expire worthless and therefore they would have a value of zero dollars at expiration since i sold them for a total premium of eighteen hundred dollars because i sold two of them at nine dollars a piece then since they expired worthless i would profit by eighteen hundred dollars in the event that square is under two hundred and eighty dollars at the time of the september 2021 expiration date so in this scenario the covered call would actually outperform simply holding the shares because in this scenario the covered call position actually generated eighteen hundred dollars in profits for me even though the share price didn't move at all the second scenario i wanna outline is if the share price falls to 225 dollars per share now since i entered this covered call position with the share price of square right around 260 dollars per share i'm rounding here just to make it a little bit easier but if the share price goes from 260 down to 225 then i'm going to lose 35 dollars per share from the point at which i enter this covered call position and on 200 shares that means i would lose seven thousand dollars from the decrease in square's share price however since the stock price is yet again below the call option strike price of 280 those 280 calls are going to be worth zero dollars at expiration and if i initially sold them for eighteen hundred dollars in premium my profit on that portion of the trade is going to be a positive eighteen hundred dollars so we can see that this actually offsets my losses on the shares of stock because since i lost approximately seven thousand dollars from that thirty five dollar decrease in the shares on 200 shares and i lost seven thousand dollars on the share position but i gained eighteen hundred dollars on the call option portion of the trade my net loss is fifty two hundred dollars from the point of entering that covered call position as opposed to losing seven thousand dollars in the event of simply holding the shares this is another example of how a covered call position can outperform simply holding shares of stock because in the event of the share price decreasing the profits from the short calls will actually offset the losses on the shares as the share price is falling the third scenario i will outline is the golden scenario so let's say the share price goes from 260 and it goes right up to that short call strike price or maybe slightly below it by the time of expiration and let's just say the stock price ends right at 279 dollars per share by the time of september 2021 expiration this is the golden scenario for a covered call position because you're going to make the most amount of money that you can make from both sides of the trade and what i mean by that is since the stock price is right at 279 at the time of september 2021 expiration those september 280 calls are going to expire worthless and again i'm going to keep the full eighteen hundred dollars that i sold those options for but i'm also going to make money on the share position because remember the stock price was right around 260 when i entered this covered call and with the stock price having increased to 279 i made an additional 19 per share and on 200 shares that means i picked up an additional 3 800 in profits so i made 3 800 on the shares and i also made 1800 on the short call position and this is the golden scenario for a covered call because i'm making the most amount of money from the call position and the share position but i also get to continue to hold my shares because those options expired out of the money so in a world of trading covered calls to perfection that is exactly what you want to see happen you want to see the stock price increase steadily towards the short calls strike price but you want to see the stock price remain slightly below that short call strike price as that option goes into expiration because you will make the most amount of money that you can make from the shares you'll be able to keep your shares and you will also have a full profit on the short call portion of that covered call position but now i want to walk into a fourth scenario and the fourth scenario is going to highlight the big problem with covered calls at least for me in this fourth scenario let's say some positive news comes out with square and the square stock price blasts off to the moon and goes to 325 dollars per share by the time of the september 2021 expiration date with the stock price at 325 dollars per share i will have made a massive gain on my stock position because since i entered this covered call position with square right around 260 dollars per share but the stock price went up to 325 dollars per share that means i would have i would have picked up an additional 65 per share and on 200 shares that means my stock position increased in value by 13 000 so that is phenomenal however with the stock price way above the short call strike price of 280 those 280 calls are going to be trading for 45 dollars per option if the stock price is at 325 now what this means is each of these call options is going to be worth four thousand five hundred dollars and i sold them each for nine hundred dollars a piece and this means i'm going to have a loss of thirty six hundred dollars per call option now since i shorted two of those options since i had 200 shares of stock that means i would lose 7 200 from the short call portion of this trade and therefore my net profit in this scenario would be my share gain of thirteen thousand dollars less the loss of seventy two hundred dollars on the short calls and that would leave me with a net profit of fifty eight hundred dollars so in this scenario we can see that the covered call actually underperformed simply holding shares of stock significantly because my share position increased in value by thirteen thousand dollars but i actually only made fifty eight hundred dollars from the point of entering this covered call position so when i say i made fifty eight hundred dollars i'm basing that off of a share price of two hundred and sixty dollars per share at the time of entering the covered call i know earlier i mentioned that i actually purchased the shares for one hundred and ninety dollars per share but in this example we are pretending that i purchased the shares for around two hundred and sixty dollars per share and then i sold the 280 calls for nine dollars each so that is what i mean when i say i made fifty eight hundred dollars from this trade and this is really my biggest problem with the covered call strategy is that you are selling all of the upside on your shares for a minimal benefit or in most cases it's a pretty small benefit everywhere else on the risk graph so what i mean by that is if we look at the risk graph of simply buying and holding shares of stock and we compare that to the risk graph of buying those shares but then also shorting a call against it we can see that we lose all of the benefit to the right side of the graph which is the profit zone on the shares and we add some benefit everywhere else to the left side of the graph so essentially we are selling all of our uncapped profit potential on the shares for a small benefit everywhere else on the risk graph so the big downside of covered calls for me is that you're taking a position with uncapped profit potential and you are deciding to put a ceiling on that profit potential in exchange for some small benefit everywhere else on the risk graph now i want to clarify that i am not saying that covered calls are bad by any means i am simply encouraging you to understand that everything in options trading and investing in general whenever you make a decision you have opportunity cost and opportunity cost is what you give up for making a particular decision in the case of covered calls the opportunity cost is if you short that call option you are going to forfeit all of your uncapped profit potential on those shares of stock and in exchange you are going to receive some small benefit everywhere else on the risk graph meaning that you are going to make more money than the shares of stock if the shares trade neutrally or if they decrease or if they increase steadily towards your short call strike price but in the event of some really positive news coming out related to that company you are not going to be able to participate in all of that upside because by selling a covered call you are giving up or selling your upside potential on the shares of stock in exchange for benefit everywhere else on that risk graph the only way to keep your shares in a covered call position when the stock price is above the short call strike price is to buy back those short calls and close them and if you buy them back for a price that is higher than what you initially sold them for you will be buying back those calls for a loss and buying back those calls for a loss will actually increase the average cost of the shares that you initially purchased so if we go back to the square example if i bought those shares for 250 per share and i sold the 280 calls for nine dollars a piece and the stock price goes to 3.25 i'm going to have a 3 600 loss on that call option position because i sold it for 9 if the stock price goes to 325 the 280 call is gonna be worth forty five dollars per option and if i buy it back for forty five dollars when i initially sold it for nine dollars i will book a 36 dollar loss on that call option and basically we can just add that 36 loss to my initial share purchase price of 250 and that will effectively increase my average cost of shares from 250 a share to 286 dollars per share since i locked in that 36 loss on the covered call position now overall i still will have made money but it will not be anywhere near the amount of money that i would have made if i simply had held the shares without shorting the call against it the message i'm trying to convey here is simply that if you own 100 shares of stock it does not automatically mean that you should be selling call options against those shares and trading covered call positions because there may be certain positions that you are invested in for the long term in the hopes of participating in significant share upside over a multi-year period and on those types of positions i personally would not recommend the covered call strategy because as i mentioned once you get into that covered call position if the stock price shoots higher than your short call strike price and you actually want to keep the shares the only way to keep your shares is going to be purchasing those call options and closing them for a loss and if you buy back those short calls for a loss you are actually going to increase the average purchase price on your initial stock purchase don't miss my in-depth guide uncovered calls which you can watch by clicking this card right here i would definitely encourage you to spend some time learning about this strategy and going through some more examples so you can further understand the things that i discussed in this video

Channel: projectfinance

Views: 29,589

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Keywords: projectfinance, projectoption, chris butler, stock market, finance

Id: no07K_T5Pz4

Length: 15min 4sec (904 seconds)

Published: Thu Jul 29 2021